In a story in early 1959 on a decision by the State of New Mexico to invest 25 percent of its $159 million Permanent Fund in common stocks (as against a previous practice of holding the entire fund in high grade bonds), it was reported that the $59 million bundle would be sunk into equities under a "slow, four-and-a-half year program," calling for stock purchases of about $1.1 million a month.

This application of what has come to be known as dollar averaging (or dollar cost averaging) is striking evidence of the high prestige of this investment formula. Although dollar averaging is usually thought of in connection with the small investor, a large number of institutions have long been practitioners— especially those such as pension funds, which deal with a constant flow of incoming cash.

The New Mexico example is significant in that it involves a sum of money already on hand. A look at the special circumstances shows why the New Mexico Investment Council, responsible for investing the money, picked the dollar averaging approach. A majority of the eight council members were described as "amateurs" in investing and were undoubtedly reluctant to take the blame for making a quick, big plunge in the market at what might turn out to be the wrong moment—especially in view of the all-time high level of stock prices at the time. As it happened, the market did rise considerably for some time after the initial decision was made. It is therefore easy to say that the plan was wrong, since some stocks could have been bought at lower prices if a sizable portion of the money had been invested right at the start. However, it must not be forgotten that quite a large amount of money was involved, and even an investment professional would not be eager to take the responsibility for deciding that any particular moment might be the appropriate time to invest $159 million. Then too, the council members were in positions of public responsibility, and were thus doubly on the spot.

Principle Of Dollar Cost Averaging

The idea of dollar cost averaging is to purchase the same dollar amount of a stock or stocks at regular intervals—monthly, quarterly or annually. Naturally, the method is especially appealing to small investors, who perhaps would not be able to buy stocks any other way, and it has been publicized primarily by the New York Stock Exchange in connection with its Monthly Investment Plan, and by mutual fund marketing organizations.

Buying stock at regular intervals seems a completely practical and relatively painless way of accumulating a sizable account. More important, however, the automatic result of buying a fixed dollar amount of stocks at each purchase point—instead of, say, a fixed number of shares—is that more shares are bought at low points, and fewer at high points. By increasing the number of shares purchased when prices are low, and cutting down as prices rise, the investor is constantly working to reduce his average cost, so that the average cost of shares purchased is always lower than the average of the prices paid.

TABLE 1
BOND STORES
Dollar Averaging Program, 1944-58

♦ Adjusted for 2-for-l split in 1945.

For a clearer picture of exactly what this means, take a look at Table 1, showing results of a hypothetical dollar cost averaging program using the stock of Bond Stores. Over the 15-year period beginning in 1944, the stock rose sharply from the twenties to a high of nearly 50 in 1946, dropped slowly in succeeding years, and recovered near the end of the period. Our dollar averaging program assumes purchases of $1,000 worth of stock on the last trading day of each year, at an approximate average of the high and low prices of that day, the last purchase being made in 1958. The first purchase is at 221/4, and the last at 211/8, with purchases in intervening years ranging from a high of 391/2 to a low of 131/8. Thus we see the operation of the plan over a complete market cycle, in which stock is bought above as well as below the initial price, and the last purchase is near the same price as the first. Neither commissions nor dividends are included in the calculations, and investment of the $1,000 in full and fractional shares is assumed.

The number of shares purchased ranges from 31.74 in 1946, to 76.19 in 1953. Over the 15-year period, a total of $15,000 is invested, and total market value is $17,878.93 at the end of the plan. While this may seem an unexciting result, it should be noted that the stock itself has not only made no progress at all, but has lost ground.

The reason for the satisfactory result despite relatively poor market performance is, as stated above, that at any time after the beginning of the plan, the average cost of shares purchased is lower than the average of prices paid, because fewer shares are bought at high prices, more at low prices. The discrepancy between the average of prices paid and average cost per share is shown in the table. Not shown in the table are dividends, which would have been considerable, amounting to about $1,000 during the last year alone. The main point, however, is that our hypothetical investor did much better by buying his stock in slow stages than he would have done by purchasing $15,000 worth at the beginning.

A Long-Term Profit Profile

Results of another hypothetical experiment, this one based on the market as a whole, are presented in a booklet published by the New York Stock Exchange.2 The booklet reports the conclusions of a study made by two professors at the Bureau of Business Research at the University of Michigan, designed to test the effectiveness of dollar averaging over a complete market cycle. The period began January 15, 1937, and ended January 15, 1950. This period had the advantage of being long enough to give a fair picture, and the market—as measured by the Dow-Jones Industrials—stood at approximately the same point at the end as at the beginning. To eliminate the danger of hindsight, the researchers used a total of 92 stocks, selected by a mechanical method, but, as it turned out, representing a broad cross-section of American industry.

It was assumed that $1,000 worth of each stock was bought on January 15—an arbitrarily selected date—of each year during the period. In addition, all dividends paid during the preceding year on the shares already held were assumed to be added to the $1,000 and invested at the same time. On this basis, a total of $1,288,000 was theoretically invested, plus $850,182 in dividends. At the end of the period, total value of the account was $3,028,855 (commissions were not considered).

An interesting twist was added by the professors when they rearranged the stocks in other random groupings consisting of fewer stocks, with essentially the same results. They then picked 27 of the best-performing stocks and ran the same test on them —here, $378,000 invested, plus reinvested dividends grew to $1,073,841. The same amount put into 27 of the worst performers grew to $693,424—less startling, but still an adequate profit.

In both these hypothetical cases it was assumed that prices ended up in very much the same spot where they started. What happens if prices are not quite so accommodating? If the stock or stocks selected by dollar cost averaging turn sour, and never recover to the starting point, is it still possible to salvage any of the investment?

Reference was made in the introduction to the oft-voiced theory that "any plan is better than no plan." In dollar averaging, this may be literally true, and the hypothetical case history presented in Table 2 is a good demonstration of this.

Building a Fortune With a "Lemon"

It would be difficult to find a stock, which was so highly regarded prior to the 1929 crash and at the same time so totally lacking in true investment merit as Radio Corporation of America. Manipulated by a highly skilled and superbly organized pool operation, the stock, which had never paid a dividend, was pushed to a mid-1929 high of over 500. A steady barrage of publicity kept the public in a state of high excitement about the company's supposedly rosy future in the new wonderland of radio. Eventually, the stock's fans were doomed to disappointment. It eventually lost over 95 percent of its market value as measured from the high point, and to this day has not recovered to its 1929 peak. Still, the stock was highly respected at the time, and an investor could hardly be blamed for picking Radio as the stock most likely to succeed in future years, or for building a dollar averaging program around it.

Table 2 assumes that $1,000 was invested in the stock at an average of the high and low prices of the last trading day of each year, beginning in 1928, and continuing until 1960, making a total investment of $33,000. (Commissions are disregarded, and it is assumed that all the $1,000 was invested in full and fractional shares.)

As the table shows, the initial purchase was made at 751/8 in 1928 (adjusted for a 5-for-l split in 1929), when 13.31 shares were bought. At the low point in 1941, the stock was selling at 21/2, and 400 shares were purchased. By 1931 the stock had already lost most of its value, and the dollar averager scored a loss, but not in proportion to the stock's decline. The table takes for granted that our intrepid investor finds it possible to raise the necessary cash in each year during the depression, and that he sinks it into his pet stock. His investment doesn't move solidly into the profit column until 1943. After that date, of course, the steady purchases at low prices in the thirties begin to pay off, and a small rise is sufficient to produce a fat profit. At the time of his purchase in 1942, for example, he holds 2,274.52 shares, which cost him $15,000 and now have a market value of $11,372.65. But his average cost is only about a point and a half above the current market price of 5, so that a rise of that amount will be enough to give him a profit if he wishes to sell out.

TABLE 2
RADIO CORPORATION OF AMERICA
Dollar Averaging Program, 1928-58

♦Adjusted for 5-for-l split in 1929.

It is interesting to note that the dollar cost averaging principle automatically insures that most of the stock held will have been bought at bargain levels. Without having to give any thought to the matter at all, the investor bought relatively few shares at the high levels of 1928 and 1929, and began to reduce his share purchases when the stock began its rise during the forties and fifties. This built-in caution at high prices is more or less typical of formula plans in general, but is especially notable in dollar averaging, and it works completely automatically. To see the effectiveness of this principle, note that the investor picked up more shares in the bargain year of 1942 alone than he did during the entire last decade of the plan—an example of shrewd investing that many a professional might envy!

Obviously, the case history has a happy ending, with the total $33,000 investment growing to nearly $170,000 by the end of 1960. This is, of course, partly a fortuitous result of the big bull market of the fifties, but even before it began, in 1950, our investor had a paper profit of more than 100 percent, even though the stock had recovered to barely a fifth of its initial market price.

"Fully Automatic" Profit Producer
Studying a few examples of this type of dollar cost averaging experience may give the reader the idea that it makes little difference whether a good stock or a bad stock is picked for the plan. Table 3, which charts the price history of two totally imaginary stocks, is evidence of this. Both Stock A and Stock B are followed through 10 regularly spaced buying points. Both stocks are at 100 at the beginning. The sum of $500 is invested in each stock at each purchase point, for a total investment in each of $5,000.

Stock A immediately goes into a sharp decline, falling to a low of 2, and recovers only a small amount of the loss, ending at 5. Stock B, on the other hand, rises 10 points between purchase points, to a high of 190 at the finish. Despite the difference between the two stocks, the plan involving the "dog" ends with a total market value of $7,650, as against only $6,830.50 for the "star performer."

The key, again, is that as a stock drops, purchases made at the low points reduce the average cost so drastically that, eventually, only a small recovery suffices to produce relatively large profits. In the case of the steadily rising stock, the number of shares bought continues to decline at each purchase point, and reduces the chance for potential profit. (It should be emphasized that these examples are imaginary and were contrived for the express purpose of showing some of the less well-known aspects of dollar averaging, and to highlight the importance of continuing the plan, even though the outlook may seem dim.)
 

TABLE 3
DOLLAR AVERAGING
Hypothetical Examples
$500 Periodic Investment in Each of Two Stocks.

It is this tendency of dollar cost averaging to produce a profit under all kinds of circumstances that has led many observers to label it the "magic formula.1' Lucile Tomlinson calls it the "unbeatable formula," which comes close to being a highly accurate description.

The few critics of dollar averaging have uncovered so little to find fault with in the method that they usually confine themselves to pointing out that poor results can ensue if the investor happens to pick a poorly suited stock. One commentator showed that, although General Motors and Woolworth were rated equally by an investment advisory service in 1939, results of two plans, one based on each stock, showed a wide difference, with Wool-worth limping in far behind.* Among stocks listed in another study as producing "mediocre results" were American Telephone and Telegraph, Pennsylvania Railroad and Coca-Cola.4 Both these comments were made in early 1958. From that point to mid-1961, Woolworth, AT&T and Coca-Cola had all more than doubled. Most stocks give fairly good results over a period of time e chances of picking what will amount to a dollar-averaging "lemon" are not too great in actual practice.

If past markets are a guide to the future, it must be assumed that, carried out over a period of years, dollar cost averaging plans based on stocks moving with the market are invariably successful in producing a profit. Miss Tomlinson studied each of the 24 10-year periods beginning January 1 of each year between the beginning of 1920 and the end of 1952, and found that, based on plans using the Dow-Jones Industrials, there "was no 10-year period in all that time when at least a 25 percent gain over cost did not exist, either at the end of the accumulation period, or within five years afterward."5 In 19 of the 24 test periods, in fact, there was a profit at the end, ranging from 2 to 110 percent. The policy of holding the stocks purchased during the 10 years for five more (with no new purchases) produced profits of 27 to 148 percent. This study covered all types of markets, some of the almost straight-up variety, others almost straight down.

How You Can Lose

All commentators on the subject agree that successful operation of a dollar averaging program requires (1) a firm decision at the outset to continue the plan over a considerable period, (2) the nerve to continue even when the outlook is blackest, and (3) some assurance that a steady flow of capital will be available.
In our RCA example, it was seen that in order to achieve the highly satisfactory results at the end of 20 years or more, it was necessary for the investor not only to put up with a paper loss for several years, beginning shortly after inauguration of the plan, but also to continue sinking money into what may have looked like a totally worthless stock in the depths of a depression.

This requirement that the plan be continued even when the outlook is black is the major weakness of dollar cost averaging— or perhaps it would be more accurate to say that this is the major weakness of the investor who uses dollar averaging. During the bear market of 1957-58, for example, which was certainly relatively mild in amplitude and short in duration, it was reported that "long-time users of dollar averaging are 'chucking it all' . . . For it's sometimes hard to know when you are showing foresight and when you are throwing good money after bad." 6 It is probable that some investors in this period were not only disgusted, but were broke, which is a condition not always susceptible to cure by will power. Naturally, stock bargains have a habit of occurring in periods when few potential customers have the means to pick them up, which is perhaps partly why they occur in the first place.

Even if it is necessary to trim purchases somewhat during times of economic stringency, it is advisable that the dollar averager keep up his program to the best of his ability. (Some institutions which use dollar averaging, not subject to the economic problems of the individual, follow a policy of stepping up purchases during periods of low prices, and shaving them in periods when the market is high. Such attempts to second-guess the market are not recommended. The danger is that the whole plan will be abandoned for the temporarily more exciting activity of calling market turns in advance.)

No one can predict, of course, how a market decline may affect him—financially or emotionally. But the would-be dollar averager should be prepared to face the problems and aggravations of a bear market when he starts his program, since it is highly probable that some discouraging slump will at least temporarily occur in any program scheduled to run for a number of years.

It is hardly surprising that dollar cost averaging has become immensely popular among investors. Currently, there are an estimated million or so active 11:21 PM 4/3/2006investment plans invclving purchases cf mutual funds. Even the Stock Exchange's Monthly Investment Plan, after a hesitant start in 1954 (it was characterized by one critic in 1955 as a "mistake" which was "falling on its face"), and against the indifference of most brokerage houses, now boasts a roster of over 100,000 adherents.

It is possible to carry out a dollar averaging program with purchases planned on any regular, periodic basis, the most common being monthly, quarterly or annually. Any interval will produce results approximately comparable to any other, and the investor should choose whatever method is most convenient. If it is decided to operate the plan using a single common stock, commissions can be reduced by choosing quarterly rather than monthly payments, since—up to a certain point—larger purchases carry a lower commission, calculated as a percentage of total market value.

As to the type of security to choose, you may pick one or more common stocks, or the shares of a mutual fund. If you choose to buy common stocks, you will undoubtedly find it advantageous to use the Monthly Investment Plan, information about which can be obtained from many New York Stock Exchange member firms. In this plan, the investor receives full and fractional shares worth exactly the amount of his regular payment (monthly or quarterly only), and full and proportional fractional dividends are paid into his account (and automatically reinvested, if he likes).

The investor who uses this plan, however, comes in for some stiff commissions. On amounts under $100, he pays six percent, substantially more than that charged on larger purchases. On amounts of more than about $600, however, they drop to about two percent or below.

In view of the fact that individual stocks will give varying results under dollar averaging, it might be worth suggesting that the investor using MIP select at least three securities, buying shares of each every third month, thus obtaining a modicum of diversification.

More popular than the MIP are mutual fund accumulation plans. These, too, have high sales charges for the most part, but there are about 25 or so with no such charge. Examples are Scudder, Stevens & Clark Common, deVegh Investing Co., and Energy Fund. These have no salesmen, and are sold only through the mail. Complete details on those with a sales load can be obtained from most brokerage houses and mutual fund marketing organizations. One way to accomplish somewhat the same end as buying a mutual fund and yet reduce the sales charge is to buy shares of closed-end investment companies listed on the Stock Exchange. Among these are Lehman Corp., Tri-Con-tinental Corp., and Madison Fund (formerly Pennroad). If purchases are over $200, the commission will be substantially smaller than the sales load of most open-end companies.

Mutual funds are ideally suited to dollar cost averaging. Plans can be set up calling for purchases of as little as $25 worth a month, and all details of security selection, record keeping, etc., are handled by management. Procedures for making the regular payments are as simple and uncomplicated as the regular payment of a telephone bill. They provide for purchases of fractional shares to fill out the exact amount invested, automatic reinvestment of dividends and/or capital gains distributions, and systematic periodic notification of the investor as to the status of his account and of his tax liability. Records of hypothetical dollar averaging programs are supplied by many of the funds in their sales literature, and results are generally satisfactory.

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